The financial industry provides a multitude of investment options for investors to manage and grow their financial resources. The different types and vehicles of investment continues to increase. With all of the different options available, individual investors often turn to managed plans or otherwise seek professional investment advice to help simplify investment decisions. In the workplace, companies and employers often provide ways to allow employees to invest a portion of their income, such as through a 401(k) program, which is an investment vehicle facilitated by the tax code.
Plan sponsors have done an excellent job of encouraging broad-based employee participation in corporate retirement plans through careful plan design and effective communication of plan benefits. They have also dedicated a significant amount of time and resources to investment education for employees. The results of these efforts are impressive. Participation has increased over the years and studies show us that employees have begun to adopt asset allocation strategies reflecting a longer-term higher risk profile, which for many employees is essential to achieving financial security in retirement.
However, little has been done for the employee who is reaching or has reached the end of his or her earning years, and therefore, has a significantly different time horizon and risk profile. Because the demographics have shifted dramatically over the last five years and millions of employees will soon be facing a life changing transition, there is a heightened awareness and concern about preparing employees for what lies ahead. How these “transitioning employees” fare after successfully accumulating a nest egg and subsequently leaving the plan will be a critical issue in the ongoing debate about the ultimate success of the private versus public retirement system. This group of employees has a unique set of concerns and investment objectives and a considerably shorter time horizon for their investments to remain undisturbed. Many individuals are seeking to create or replace a predictable income stream, and while return is very important, preserving principal is critical. Upon departure from the plan, the transitioning employee often faces a near term need for income and in today's market has difficulty obtaining competitive, conservative investment products. Some of these individuals also have a need for continued tax deferral and, due to a longer life expectancy, must continue to seek a combination of income producing and equity investments. For all transitioning employees, maximizing the return or income from their conservative investments is imperative. Strong returns create a higher level of current income making the need to redeem principal less likely, hence keeping their nest egg in tact. Tax deferral is also an ongoing concern, as individuals look to pay taxes on the income used versus what their investments may earn.
The corporate plan sponsor has traditionally provided annuities to employees as part of the defined benefit program. In general, an annuity is a series of payments of set size and frequency, often to a retired person (although this need not be the case). More particularly, an annuity is a contract sold by an issuer such as an insurance company, which is designed to provide payments to the annuity holder at specified intervals. Annuities are relatively safe investments, and the capital in annuities grows tax-deferred. Annuities are purchased for plan participants, for example, upon retirement, departure from the plan, or when a defined benefit plan is terminated. Defined benefit disbursements are technically a company provided benefit funded and distributed by the corporation. Many corporate plan sponsors offer an annuity option to employees versus a lump sum cash payment of their account balance.
While a number of plan sponsors provide for an annuity placement option in their 401(k) or other “qualified” retirement plans, few companies actually have a program in place giving plan participants the opportunity to purchase an annuity. Therefore, while annuities have long been an excellent way of providing individuals the means to create a predictable income stream and earn interest on a tax-deferred basis, competitive pricing has always been an issue for both institutional and retail products. The internal costs and distribution fees associated with retail annuity products are prohibitive and significantly diminish the income benefits to investors. While group or institutional annuity pricing is substantially better than retail, the process used by institutions to obtain group annuity contracts leaves substantial room for improvement.
Historically, because group annuities were funded by the corporation as a pension benefit, the corporate sponsor selected the issuing insurance company and the type of contract offered to employees. Contracts offered were generally designed to replace an employee's income stream that had accrued to them under the terms of the corporate pension plan, or to convert a lump sum balance to a specified income stream. The placement of group annuity contracts has traditionally been handled through the Human Resources department, rather than the pension investment group. This has caused annuities to be treated like a benefit rather than the investment that they are. Most often the business was awarded to one or more insurance companies based on previous or existing benefit provider relationships.
Due to constraints on time and resources, plan sponsors have focused on obtaining arrangements with a limited number of carriers that fix the contract expenses and promise the best possible pricing at the time of the quote request. The plan sponsors have believed that the insurance companies are giving them a significant pricing benefit. Insurance companies have encouraged this type of arrangement, because this way it is basically guaranteed that they will receive a portion of what ever business is placed.
On the surface this arrangement looks fair, because plan sponsors are getting generous concessions on the “costs” that are disclosed to them, and the assumption is that these costs are significant. Unfortunately, it is the costs that the plan sponsor does not see that have a significant affect on pricing. In fact, contract expenses are only a minimal factor in determining price relative to other constraints that actually drive pricing and make up the bulk of the cost to buyers. The driving force behind pricing stems from a number of issues, such as an issuer's own current book of business, asset pool, risk assumptions and internal economic outlook. At any time, an issuer's best possible offer may be substantially below the market, resulting in a significant discrepancy from one issuer's quote to the next.
Even with a competitive bidding session where issuers are forced to use the broader market as their bogie for pricing, equivalent or better credits can exceed peer pricing by 4% to 12%. When a competitive bidding session is not used, the pricing differential can more than double. For plan sponsors that are terminating pension liabilities, this equates to substantial increases in the cost to fund a group annuity contract. For employees who are trying to establish a monthly benefit, this causes a significant reduction in income. Either way the result is less than optimal.
In addition there is another hidden cost driver of which buyers may be unaware. Annuities are priced one of two ways. They are either sold on an institutional (group) basis, or on a retail (individual) basis. Retail annuities carry significantly higher commissions, as they are sold individually. Group annuities have far lower sales charges associated with them because they are sold in volume. However, that is only one of the pricing disadvantages to retail annuity products. There is actually a pricing disadvantage that occurs internally, due to risk charges, before any commissions are added. The retail annuity is often priced using a different set of internal risk assumptions creating higher risk assumptions for different lines of business from the onset, prior to the addition of any sales charges or commissions. So the very same product when sold to an individual within a group can be significantly less expensive than when sold to an individual alone, even before retail or distribution costs are added on. This affects the retail investor with an additive effect, thereby significantly diminishing the retail investor's monthly income from any annuity product purchased apart from a group.
A problem plan sponsors and other fiduciaries face is that carrying out a manual competitive bidding process amongst a diverse group of insurance companies would require time, knowledge, and resources that most companies do not have within their human resources staff. The typical process lacks several important elements: objectivity (deals are typically relationship-driven), a comprehensive search (minimal number of providers providing quotes), and competitive pricing (no real competition due to too few providers), and no system to handle the information flow involved in a robust quote process. As a result, when a corporate plan sponsor determines that more expertise or resources are needed to handle the annuity placement process, they generally outsource the effort with, for example, a financial advisor or benefits consultant.
When the life insurance industry began to experience deterioration and eventually insolvencies, plan sponsor and regulator concerns started to emerge. The environment shifted drastically in 1995 when the Department of Labor (DOL) issued its interpretive bulletin 95-1 addressing fiduciary responsibility in selecting an annuity provider for the purpose of distributing benefits from an employer sponsored pension plan. This bulletin clarified that an objective, thorough, and analytical search for annuity providers was required to meet the fiduciary obligation of plan sponsors under the Employee Retirement Income Security Act (ERISA). It also addresses the issues of conflict of interest and independent expert advice. This was an important clarification by the DOL on fiduciary duty, as it relates to annuity selection. This has resulted in raising the bar for plan sponsors and other fiduciaries, relative to the annuity selection and purchase process.
Another problem facing the insurance/annuity industry deals with the general availability of annuities to individuals, even where those individuals are involved with a defined benefit plan provided by their employers or other plan sponsor. Presently, insurance companies generally write group contracts for facilitating annuity purchases by plan participants to the corporate plan sponsor or to an agent of the plan appointed by the plan. A plan that can offer group annuities to its participants must have language in the plan document that allows for this distribution option. Historically all pension funds (defined benefit plans) allowed for this option, and plan sponsors were inclined to also provide it in their 401(k) plans. The majority of group annuity contracts were written to defined benefit plans.
In the mid-nineties, around the time the Department of Labor (DOL) issued 95-1, the thinking began to shift. Plan sponsors began to eliminate the annuity option from their existing defined contribution plans, and it was seldom included in any new plan creation. Corporate plan sponsors had several problems with providing the option. Complying with the DOL guidelines for annuity selection meant increased time, high-level administration, and increased fiduciary liability for the plan sponsors. Plan sponsors felt that if the process did not comply with 95-1 and was not fully documented to prove it, the company could be exposed to significant future liability. Additionally, in order to actually comply with 95-1, plan sponsors had to move away from the common practice of allowing the insurance company(s) in which they did the most business with handle the annuity requests by participants, with little concern for competitive pricing, etc. As a result, only an estimated 20% of current defined contribution plans still have an annuity option, and plan consultants firmly discourage any sponsor from including such an option.
This being the case, insurance companies have seen their group annuity business dwindle. And, with the markets performing as they had through the latter half of the nineties, little has been done by insurance companies to try to find new avenues for offering group annuities. Generally insurance company contracts were designed to be written to plan sponsors or agents of the plan, and additionally, group annuity contracts are written to plans that offer the annuity option for distributions for which the vast majority of plans no longer offer such an option.
Therefore, a need exists in the financial industry to provide a manner in which all individuals have access to annuities at group/institutional rates rather than at individual retail rates, even if the individuals' plan sponsors do not provide an annuity option in their plans. A further need exists to facilitate such transactions between annuity seekers and the various annuity providers, without requiring plan sponsors to assume the costs and liabilities that may accompany annuity contracts. The Income Solutions model of the present invention makes it possible for any plan sponsor or fiduciary of any size to cost-effectively implement an acceptable annuity selection process, while ensuring optimum, institutional pricing for the individual investor. The Income Solutions platform of the present invention also facilitates annuity purchases for both defined-benefit and defined-contribution plan participants. The present invention further provides a solution to the limited annuity availability problem that is plaguing the annuity industry, by facilitating group contract creation without shifting the cost and liability burden to plan sponsors. The present invention thus provides solutions to the shortcomings of the prior art, and provides numerous advantages over prior art annuity management methodologies.